Westpac points to risks from policy uncertainty index spike

The performance of bond and equity markets is starting to baffle investment experts given uncertainty over the United States government shutdown, which started a week ago.

Since the US government shutdown last Thursday – for the 17th time in history – US 10-year Treasury yields have barely reacted, while equities are just starting to show signs of vulnerability.

Westpac
New York-based senior currency strategist
Richard Franulovich
thinks the stability in long term bond yields and equities is getting “harder to fathom" in light of indicators such as the economic policy uncertainty index (EPUI).

The EPUI, developed by American academics, measures uncertainty by taking into account economic variables, government taxes and the mention of the words “economic policy uncertainty" in newspaper articles.

Surge

The index has surged over the past week, suggesting a heightened level of risk in financial markets.

The index has also doubled over the last three months – matching the period seen in late 2008, around the time that Lehman Brothers collapsed.

“To be fair, the surge in policy ­uncertainty is unlikely to be sustained for the entirety of October since we assume a solution will eventually arrive. However, the surge in the EPUI in the first eight days of October ­nonetheless highlights the risks," ­Franulovich said.

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Selling started to accelerate in US stocks on Tuesday with the Dow Jones closing 1.07 per cent lower, while the S&P 500 was down 1.23 per cent and the Nasdaq dropped 2 per cent.

The local sharemarket also followed suit but managed to finished 0.07 per cent higher at 5153 points on Wednesday, helped by confirmation of the appointment of
Janet Yellen
as the new chair of the US Federal Reserve.

Consumer sentiment index

Also keeping a lid on gains was the release of the Westpac-Melbourne Institute consumer sentiment index which fell by 2.1 per cent in October from 110.6 in September to 108.3 in October.

Speaking about the result, Westpac chief economist
Bill Evans
said “The shutdown of the US government and media speculation around a US government default would also have unnerved respondents".

Also affecting sentiment has been strength in the Australian dollar, which continued to range trade slightly above US94¢ on Wednesday.

A key US measure of investor anxiety, the Chicago Board Options Exchange Volatility Index ticked above 20 for the first time since June 24 with investors seemingly willing to pay more for protection against a sudden drop on the S&P 500.

Mr Franulovich also pointed out that the cost to insure against a US default by the government, as measured by one year US sovereign CDS has risen too, from 11 basis points in late September to 59 basis points.

“T-bills and sovereign CDS of course more explicitly discounts default risk than other instruments. But even so, surely the paralysis in Washington has dented confidence and damaged the US growth outlook such that the equities and bond yields should be under a lot more pressure?".

The International Monetary Fund has lowered its growth forecast for the global economy and warned the outlook could get bleaker if the US political stand-off over finances drags on.